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Understanding Drawdown & Its Relation With Position Size

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Introduction

Do you know that there is a safe way to choose the maximum lot size when you trade? That too while keeping your account safe from blowing when a losing streak of trades occur? To constantly stay in the game and be able to recover from losses requires patience, clarity, and, more importantly – optimal Position sizing. The position size in simple words is how much a trader invests in each trade. There are different models deployed to reach the optimal position sizing depending on the objective of the trade. Before that, let’s first understand what drawdown is and how it is related to position sizing.

What is the maximum drawdown?

The maximum drawdown is the biggest drop in the accumulated profit chart and, consequently, that of the trading capital. Imagine a situation where a trader had 200 pips in profit after a number of trades, and on the following days’ profit dropped to 136 pips before he can make new accumulated high.

So, the drawdown here was 200-136 = 64 pips

When this drawdown increases, it reaches a level (negative drawdown), after which it becomes impossible to trade (due to loss of trading capital). Maximum drawdown is the loss that the trader can take in order to survive in the market and be able to continue trading.

How is drawdown related to position sizing?

Taking the above example, let us assume that the trading capital was $500 and the trader trades with a lot size of 0.01. The drawdown he experienced was 64 pips, which is $6.4 (1 Pip = $0.1). So the amount of money he/she risking in this trade is 6.4/500 x 100 = 1.28% of the account size.

Now let us see how this drawdown increases with a change in position size.

How much drawdown can I handle so that it doesn’t affect the mental state and my trading style?

As you can see below, the drawdown % increase as the lot size increases and the account gets into an unsustainable state (Especially when the Trading Capital is $500). Hence you need to calculate risk based on your risk tolerance drawdown.

The right way to look at drawdown and position size

Typically, the drawdown occurs after a series of consecutive losses. The very first thing a trader needs to do is to analyze and figure out the number of losing trader he/she can endure. Depending on that, the maximum risk percentage should be defined. So essentially, this percentage is the maximum amount of trading capital a trader affords to lose. If the losses cross this percentage, his/her account get unsustainable.

For instance, I can bear a maximum drawdown of 20%. So I should be willing to design a strategy and chose my trading size in such a way that it is very unlikely for me to reach the 20% drawdown. Let’s denote the number of losing streaks as N. I should make sure that my strategy has a winning percentage of at least 50% or more with high RRRs. Let’s assume the maximum number of losing streaks I can afford is 10 (i.e. N=10).

Dividing the maximum drawdown (20%) with N (10) gives 2%. This means that I cannot risk more than 2% of my trading capital on a trade to sustain in the market. If I have more than one open trading position, I should be distributing the risk among all of the open positions. So here, if I have 2 open positions, I shouldn’t be risking more than 1% in each of the trades. This is one of the best ways to look at drawdown and position size.

Different approaches to position sizing

Defined Percentage Risk

In this position sizing strategy, we risk a fixed percentage of the trading capital (e.g., 1%) for each trade. This is followed by most of the traders across the world and it is pretty simple to use as well. Essentially, the trader is required to put the stop-loss more accurately and not randomly to prevent the stop-loss hunt. This might sound pretty easy but it needs a lot of discipline to overcome the greed and not raise the position size when you see a clear profitable trading signal.

The Kelly Criterion Model

John Kelly described this criterion pretty long ago, which computes the optimal position size for a series of trades.

Kelly Percentage = W – [(1-W) / R)

Where, W – Winning probability and R – Profit/Loss ratio

When a trader keeps a record of all their trades, they can calculate their winning probability and profit/loss ratio. Then, they can use them in the above equation to calculate the optimal position size.

Conclusion

You now know the importance of position size and its relation to drawdown. By using this, leverage can also be used appropriately to avoid blowing-up your account because of the drawdown. By doing this, you can maximize your earnings and reduce drawdown to an acceptable value.

Our suggestion for you is to use a trading strategy for a long time. If a strategy hasn’t been tried many times, the big drawdown might not have appeared yet. The bigger the history of using the strategy, the more confidence you will get to increase the lot size. Cheers!

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